Business Scenario
Hedging against an oil price increase
Consider the case of a utility organization that is importing crude oil. Any increase in the price of crude oil increases its expenses. For instance, consider the organization to be importing 1000 barrels of oil each during the months of August and September. At the current price of USD 85 per barrel the firm calculates its expenses as USD 85,000 (1000 barrels * USD 85) in August and USD 85,000 in September as well. So his total expected expenses would be USD 170,000. Now, if the price of crude oil increases to USD 100 by September then the firm will have to pay more per barrel in September thereby increasing its expenses. Its total expenses would now be USD 185,000, thereby spending USD 15,000 more than what it had planned in August. This can be considered as a loss. Now, if the firm wants to lock it’s expenses at USD 170,000 for the total period August and September, it needs to enter the futures market and buy futures contracts worth that amount in August and when prices increase in September sell those contracts for the higher price, thereby making profits which cover the losses it makes in the goods market.
This is explained in the table below:
| |
Spot Market (Without Hedging) |
Futures Market (With Hedging) |
| Expected expenses in
August for its purchases in August and September (Since
market price of crude oil is $ 85 per barrel in August)
|
August: $ 85,000
September: $ 85,000
Total = $170,000 for Aug and Sept
|
|
Actual
expenses in Aug
Market Price = $ 85 per barrel
|
$ 85 per barrel (1000 barrels)
= $ 85,000
|
Buys 4 futures contracts(250 barrels per contract size) at the futures price of USD 85(8*250*85)
= $85,000
|
Actual
expenses in Sept
Market Price = $ 100 per barrel
|
$ 100 per barrel
=$ 100,000
|
Sells the 4 futures contracts at the price of $100 (4*250*100)
=$100,000
|
| Total Amount spent |
$ 185,000 ($85,000+$100,000) |
|
| |
Losses from the expected expenses
= $ 185,000 - $170,000 = $15,000
|
Profits from futures transaction
= $100,000- $85,000 = $15,000
|